Toomre Capital Markets LLC

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Cantor's Lutnick: CDO Market is Now Shut Down

Reuters is reporting the obvious on Monday, November 5th, 2007: Cantor CEO says big CDO market has shut down. Apparently Cantor Fitzgerald LP Chairman and Chief Executive Howard Lutnick publicly has stated what Toomre Capital Markets LLC ("TCM") and many others have been saying for several weeks now: There are effectively no buyers and what people and organizations own on their books in CDO format, sub-prime mortgage format or just as general collateral has one place to go: DOWN.

The complete CDO market seizure means that there still are tremendous losses to come for those financial intermediaries that retained CDO bond classes, those investment portfolios that invested in them and, perhaps most importantly, all of those organizations that put on CDO "arbitrage" strategies. Perhaps people have not fully appreciated the full impact of this credit crisis? Maybe $25 Billion of the originally estimated $100 Billion dollars in losses have been reported by investment banks and global banking institutions. Where is that $75 Billion in other losses lurking? And assumes that the original $100 Billion number was even conservative enough… Some are already speculating that the total losses from CDO investments may total more than $250 Billion.

"The big CDO market is gone," Lutnick told the Reuters Finance Summit. "You'll see all the banks step out of it because they just can't do (the deals anymore) because they won't be able to churn them out to the buyers because the buyers are gone." Lutnick, whose firm controls one of the world's largest bond brokerages, said the easy buyers of CDOs have left the market. That leaves what he described as sophisticated buyers, who are willing to do their own math and find their own value for distressed CDOs. That will spawn a market for packaging the securities in a way that appeals to those investors, Lutnick said.

"The (CDO) repackaging business will be there, and it will grow enormously," Lutnick said. "No one is going to believe anybody anymore (about CDOs)," Lutnick said. "It's not just about the rating. You have to run your own math and come to your own view."

This last statement points directly at what the current problems with CDOs are: Trust and a complete lack thereof. If a CDO bond class can go from AAA to BB in one swell swoop, why the F*** even bother to consider making such a high-grade investment? Remember for high-grade (ie investment grade portfolios) maybe fifty basis points of performance separates a top quartile manager from the average portfolio manager. Having bonds in the portfolio that can lose 20%, 50% or even more of their value does a real dozy on portfolio performance and one had better hope that the CDO bond concentration in a portfolio is extremely low (to hopefully non-existent)!

Remember that there are literally billions of dollars of these CDOs sprinkled in small and sometime extremely large portfolio concentrations around the world. This CDO issue is not relegated to some distant portion of the global investment markets. Most investment institutions have at least some exposure to CDO bond classes since supposedly so much of an issue's structure was supposedly AAA.

The portfolio return reports for large, high-grade investment managers and hedge funds during the fourth quarter of 2007 will be extremely interesting to watch. How many funds and portfolios had their CDO's marked at 90% on the dollar (as UBS apparently did at 3Q quarter-end)? How many adopted Merrill Lynch's marks in the low 60s (as MER apparently did for their revised earnings announcement)? And how many had the bonds marked in the low 40s where apparently what few privately negotiated transactions have actually recently traded at? The losses in some investment portfolios are going to be truly horrific and surprise more than a few pension plans and individual investors.

Toomre Capital Markets LLC ("TCM") strongly suspects that the credit markets have not yet heard the end of CDO credit disaster. What is the next shoe to drop? A complete seizure in the municipal bond markets when the large monoline insurers like Ambac and MBIA lose their coveted AAA ratings? What are all of those "insured" municipal bonds going to be worth? Reader comments and thoughts are most welcome.